Cloudflare, Inc. (NET) Earnings Call Transcript & Summary

Thanks, everyone, for joining us. My name is Sterling Auty, software technology analyst here at JP Morgan. Very happy to have with us the CFO of Cloudflare, Thomas Seifert; as well as Jayson Noland, who's Head of Investor Relations. [Operator Instructions] With that, again, guys, thanks for joining us, and thank you for the flexibility. We're in a new time slot for this presentation, maybe you can give investors a heads up. Why did we have to change our time slot?

Yes. So first of all, thanks for hosting us. We're supposed to be here Tuesday but we executed a convertible transaction with many banks, but among others, yours. And so we had to -- we couldn't join you on Tuesday and had to push out to Thursday -- today.

Well I'm glad we're able to accommodate.

In my conversations with investors, maybe we can get started with -- I still think there's a lot of confusion over investors understanding the difference between what Cloudflare offers and where your position in the market is vis-à-vis other traditional CDN companies like Akamai. Can you help maybe with an overview of kind of a compare and contrast?

Yes. I mean the easy answer would be, we were never designed to be a CDN. If we -- if our founder were here, he would say, "When I pitched the idea of delivering security and performance services and products like load balancing and firewalls of a network, everybody said to me, that is all great, but you will add a bump in the wire and that is why it's not going to work." So the -- from the very beginning, Cloudflare's network was designed with speed in mind to deliver products like firewalls and load balancing and others without a bump in the wire. And as -- doing that, we literally developed the fastest CDN network. Not deliver so much content and media, but deliver products like load balancing and firewalls. And now if I -- if you pull up a site like DNS performance and -- that measures CDN speed, the remarkable thing is that Cloudflare is by far the fastest network out there. I think if you were to pull it up now, it probably would say a query on the Cloudflare network takes about 11 microseconds. And then there's a long distance to an Akamai, maybe 44 milliseconds, or a Google. So the speed of the network is by factors faster, not because we wanted to be a CDN, but we wanted to deliver products like I mentioned without adding latency to the delivery. And in doing this, we designed a network that is rather unique. We use off-the-shelf hardware that sits in all the points of presence we have, more than 200 today, but it runs a homogeneous software stack. So all of our services, all of our products run on every server we have in every city we have and in every point of presence we have. And that allows us really to manage demand and cost and capacity across the global footprint. And in terms of delivering these products, the ease of use of delivery is quite remarkable. I mean we don't need any professional services in order to get behind our network. We've been onboarding 1,000 customers in the first quarter in our Access product, literally without a customer support engineer or anything showing up on-premise for the customers we have. So we have a CDN capability to deliver products that are security and performance products, but it was not really designed to be a CDN. We just got the fastest CDN network as a part of getting the business model in place.

So along those lines, maybe can you give a sense -- I think investors understand that those traditional CDNs are -- get a lot of their revenue from distributing video, music, software downloads. How much of your revenue comes from those traditional CDN sources?

Very little. So we cash content but we are not really pursuing what you guys call the OTT deals. They are -- that is just moving down bits at low margins. When we prepared for our IPO last year and you have this page in U.S., one that says, "Show us your customers by verticals," we -- for industrials, we could have had 1,000 mining companies. But it was really difficult for us to put media names on there that people would recognize. So our exposure to that business is very little. And we think those -- the large amount of -- the big amount of those deals is not very attractive. They're low-margin deals. There's no value-add shifting bits from one place for another, and that's why our exposure to those verticals is really very limited. That might change if we find a way to deliver media and video streams using the advantages of the architecture of our network at high gross margins, that might change. But just pursuing volume just for the sake of it, it's not what we are after.

So based on that, who is the primary competition for the bulk of your revenue?

Good question. So we -- I think we bucketed into 3 areas. They are the hardware guys. This is literally where we take most of our budget dollars away from, where you replace on-premise hardware that could be the Riverbeds and the F5s and the Ciscos and the Palo Altos, the Check Points of this world. And now on the Access side, the Citrix, the -- would fall into that category. That is where most of our TAM rests today. We also compete against, what we call, point solution providers, companies that have a network like ours but offer a very limited amount of services from their network. Fastly would fall into that category. We would say that an Akamai is, in our opinion, in that category. And then the people that we -- the folks that we are really -- think about and that keep us up at night are the big cloud providers. Today, we have really beneficial or really good relationships with them. Most of the big ones have been investors in Cloudflare in the beginning. But if you were to ask Matthew, What keeps you up at night? He would probably say it's Amazon.

So what would you characterize as the core competitive advantage against each of those groups? Maybe starting with -- you mentioned a number of the hardware vendors that are the edge of today's existing corporate networks. What is the kind of value proposition that motivates a customer to switch to a Cloudflare service?

I mean -- I think those guys are just on the wrong side of history. And in the crisis currently, the COVID-19 crisis, shows that we lean so hard today on the Internet to help us manage our businesses and get through this crisis. So data shifting to the cloud, the digital transformation that is happening is really a tailwind to us. We win because we offer products and ROI. As I said, we've been onboarding 1,000 Access customers in the first quarter alone, literally without -- of course, without shipping hardware, it's literally without sending any support people out in order to achieve that. So this is where we win today. And this is where a lot of our business comes from. Many of the point solution providers -- and here, it's really the press of the platform that allows us to prevail. We offer today more than 20 products across security, performance and reliability. And customers have taken different mixes of these products, so that makes it sometimes really difficult to talk to folks like you who say, "What does a typical customer look like?" And that's really hard because in terms of what products they take from us, the combination of those 20 products is very unique. But it also makes us -- it really, really difficult and hard for others to compete with us. So the press of the product portfolio, our ability to add and upsell and cross-sell and expand is rather unique. That is, I think, the true competitive advantage. The points of presence we have, the speed of the network really helps us in the second category. Then when it comes to the big cloud providers, I think there are 2 things. Our footprint in China currently is very unique that we are able to offer one control plane for our customers to manage one network across the plane -- across the planet. We have -- we built that footprint with Baidu and have presence in 25 cities in China today. We just signed another agreement partnership -- agreement with JD in the -- at the beginning of the year that will take our presence up to 150 cities in China over the next 3 years. So that is certainly something that is unique. But I think the most important quality that customers look and see in us is that we are this neutral provider that can sit in front of many public clouds. And they are able to avoid lock-in. They are able to use us as a -- almost like a control and steering mechanism to move data between different cloud providers. This neutral stance enabling multi-cloud setups, I think, is what is helping us to perform against the big cloud providers.

So with that being said, Thomas, what does a typical customer look like in terms of what they take? No, I'm just kidding. Sorry. You've touched upon how big of a competitive advantage is the breadth of the network. So when I look at the number of points of presence that you have around the globe as well as the geographic coverage that you have, how much of a differentiator is that as a competitive weapon?

I think it's unique. And it -- and the impact comes in various factors. So first of all, having that big footprint really minimizes the latency between anything that wants to connect in us. We say today that we are less than 100 milliseconds away from 99% of the developed world's Internet. And if you think about IoT and devices like that, minimizing the latency that is between us and whatever connects becomes more and more important. And that is enabled by the big footprint. What is less obvious is that the big footprint allows us to really manage our costs well. We turned a lot of variable costs into fixed costs, but being able to manage capacity and demand across this global network is really the true secret sauce between -- behind our gross margin performance. We've been running at north of 78% in the first quarter. It has been consistently at that level. We said on our last earnings call that traffic in the network during this crisis went up by a factor of [ 1.6 ]. And we digested that increase in traffic literally without even a dent in our gross margin performance gives you an idea of the elasticity, the flexibility but also the cost efficiency of that footprint. And that is, to a certain extent, also driven by the broad footprint we have.

So I want to dive into that efficiency in terms of the gross margins. Traditionally, Akamai has what their -- I believe it was called the Akamai Preferred Partner Program. So they would work with telecom carrier partners that they're embedded in, help them with network grooming and the benefit that they're giving to those network partners is what allowed them to end up with attractive pricing. Are you managing -- are you providing those type of capabilities? Or what else helps you keep the prices at a level to drive these level of gross margins?

Yes. I mean this is where the long tail of our business model comes into play. You can go to the most remote places on the planet. And we have 3 PoPs in Pakistan or in Egypt. And if you look at the largest sites in a place like that, it might be Google and Facebook on #1 and #2. But then the next largest 50 sites are probably all sitting on Cloudflare, and they might be streaming the World Cricket Series (sic) [ World Series Cricket ] in Pakistan. And bundling all this demand locally gives us huge leverage because this allows the local ISPs to -- instead of back pulling traffic from the next Internet node, bringing us on site and allowing us to colocate within their ISP center, and the data centers allows them to save a lot of cost. And in most of the -- these places, they make revenue off of selling bandwidth. So us helping them to provide a faster experience allows them also not only to decrease their costs but also to increase their revenue. And that gives us this leverage to get to extremely attractive colocation and peering agreements in pretty much every part of the world. So this is where, truly, this idea of starting at the long tail of this market in the very beginning comes into play. And we said we are sitting now today in front of north of 27 million Internet properties. We have more than 2.8 million free and paying customers. And the free customers allow us to get this bargaining power, if you want to say so, that allows us to get to those advantageous agreements.

For the benefit of the investors, because I get this question quite a bit, when you talk about Internet properties, what's included in that?

It could be websites. It could be APIs. It could be drones. It could be cars. It is anything that wants to connect at a certain point in time.

Makes sense. A couple of questions from the audience. The first one is following up on what we're talking about earlier. Vis-à-vis when you're looking to compete against a networking company like Cisco, what's the opening that you're looking to kind of pry into to win that foothold in a customer and start to take some of the opportunity and how may have that changed in light of COVID?

That's a good question. The hard part is like, what does a typical customer looks like? It depends. So you can only categorize this. If you are a big financial institution like JP Morgan, the likelihood that you end up coming to us is probably because of the security need, right, some large DDoS attack. Some -- in COVID-19 now, all of a sudden, you have to enable 40,000, 50,000 employees working from home and shipping hardware and putting VPN capacity in place for -- overnight is really difficult. But we would onboard, even a company like you, in -- within hours, probably days at the very most. So it's a very specific need. And -- or you might be -- we had an e-health care company in Europe that offered their video consultation products for free in order to help physicians to continue to work. And all of a sudden, their network traffic spiked. So they came to us because all of a sudden, they had to load balance significant traffic increases across a large global footprint. So this is how normally business starts with us. They're very typical. And then you sit on our network, in here, immediate visibility of what traffic goes to your websites, where traffic comes from. And literally, every product and service we have is only a mouse click away from every customer. So we can go back and say, "Did you realize that 40% of the bandwidth you pay are malicious bots that are trying to take information from your websites? If you enable our bot-mitigation product, you are instantly able to reduce that." So expansion is really then a lot easier. And we call that -- we win this war of attrition. We sit in front of a customer with 1 or 2 products. And then we have a lot of visibility of how you should expand a customer from a usage perspective. And once a customer uses 4 or more of our products, and 70% do, then this becomes a rather sticky relationship.

Let's use that as a segue over to talk a bit about COVID. Just in general, would you characterize COVID as a headwind or a tailwind to your business?

I mean over the long term, it's going to be a tailwind. In the short term, there are gives and takes in terms of -- we talked about it at length on our earnings call. Of course, we -- there will be concessions. There will be some customers that struggle. But what you would literally see is that it accelerates, by factors, the companies and customers transforming and -- there and digitalizing their business models. And in this crisis, we lean more than ever on the Internet to get our jobs done, to keep our business models alive. And that was Cloudflare's mission. So a tailwind, for sure. And there might be some hiccups in the short term, but over the long run, it's going to be a net positive.

One of the 2, I think, key concerns that investors have had with COVID is: one, exposure to SMB that might be disproportionately hurt by the situation; and then two, exposure to hard-hit industries like travel, hospitality, et cetera. How would you kind of characterize the Cloudflare business along those lines?

Well, let's start with your second point first. Our exposure to the hardest-hit industries is really not a lot. We say about 8% of our business is associated with verticals where you would think there's a bigger exposure like transportation or hospitality or retail or travel, so about 8%. But not -- a lot of these customers that are in those verticals that are with us are far along digitalizing their business model. So while there's 8% exposure, and not everybody in that vertical is really hit hard by the COVID-19 crisis. On your -- regarding your second question -- first question, there are some interesting things. That is where we started. I mean we have 2 businesses. There's our contracted businesses, what others would call enterprise business, where you negotiate a contract 1, 2, 3 years. And then there's our pay-as-you-go business, that's where the company originally started, where folks just give us a credit card and pay us $20 or $200 a month. And that is -- the customers that are sitting there are developers, small- and medium-sized businesses. So in terms of customer numbers, that is a significant number. In terms of revenue exposure, it's less than people think. That is where we started, but our enterprise business has grown so much over the last 2 years that less than 20% of revenue sit in the SMB vertical today. To our surprise, we've seen the strongest quarter in years in the first quarter in the SMB segment. And I think in part, it's something that others have seen, too, like Shopify. If you have a restaurant and all of a sudden, you cannot have customers visit your premises, you have to deal with that. And there's a lot of small- and medium-sized businesses that have to jump and switch to the Internet in order to develop or keep their business model alive. And this is what we have seen in the first quarter. And in quarter-to-date, in the second quarter, that trend has continued. So we have less exposure than people think, it's less than 20% today. And we've seen the strongest quarter from a new customer acquisition perspective in the first quarter in -- literally in years.

At the very end, you touched upon the next point, which was going to be -- if pay-as-you-go is so strong, how much of it is new logo acquisition versus existing customers in that group taking up more product?

I think it's the first. If you look at our numbers, new customer acquisition has really picked up in this segment. And when I say it has been the strongest quarter in a while, it's in new logo acquisition.

And then let's talk about Access or what was originally called Cloudflare for Teams. First for investors, what actually does this solution do? And who does it compete against?

Yes. So it's actually the other way around. We started with Access, and now we -- it's a whole portfolio of products that we will offer under what we call Cloudflare for Teams. And Cloudflare for Access is literally a VPN replacement product. And as such, it primarily competes with the VPN providers that's out there, the Ciscos, the Citrixes, the F5s, that is where it competes against. And there are also some point solution providers, Zscaler's ZPA product would fall into that category. So this is where we started. This is what we launched in January. And that is what we, because of the crisis, decided to offer for free, at least until 1st of September this year. Cloudflare for Teams will be a portfolio of products that will include Access. But we are also launching a Gateway product in the summer. And we announced that we acquired a company, S2, that is -- that got us access to a browser-isolation technology that is very unique. Those 3 products will be bundled under an umbrella that we call Cloudflare for Teams.

What does Gateway actually provide?

Well, it's -- what is the closest product to that? It would be the Zscaler ZIA product, their Internet Access product. So this is what is -- what it is going to emulate.

Got it. And what's been the usage pattern for the more than 1,000 companies that have come on board? How active are they utilizing the product?

It's very interesting. And I think we get the full spectrum. I mean you have really small companies that jumped on it literally overnight, up to very large -- we talked about a very large pharmaceutical company that literally went from 0 to 15,000 seats within days. And anything in between, large companies that just put dedicated critical teams behind Cloudflare for the time being. I think what impressed me most, Sterling, was that we've been able to -- we just launched the product in January, and that we have been able to onboard a massive amount of customers, small to really big, in a very short period of time. And as I said before, without any Cloudflare person visiting a customer or being on-premise. And if you compare that to how difficult it is to install and provision a hardware box-based VPN infrastructure, and then -- now we've seen customers that showed us e-mails from the IT teams. "If you are not on your VPN, please -- if you're not using the Internet, please get off your VPN, we need the capacity." So the elasticity of the product and the ease of installation are really incredible.

So how is the uptake of that compared to other products that you've introduced? Well, let's start with that.

I think that -- before COVID-19, if you had asked us or had asked me, "Do you think you will onboard 1,000 customers in the first quarter?" I probably would have smiled and said, "Very unlikely." So COVID-19, for sure, has provided some tailwinds to that. And in the beginning, we offered it only for free, literally for small- and medium-sized businesses because -- and then we were literally asked to extend that. So today, it's still literally free for everybody, at least until September. So that has a certain uniqueness to that. But I -- if you look at products like Magic Transit that we launched last year or bot-mitigation product that we launched, we normally are able to ramp new products in terms of adoption really fast. I mean each product is integrated in this unique, homogeneous software stack. So it's immediately available for every customer that is on our platform, and it's literally, as I said before, a mouse click away. So in terms of using every new product as an expansion vehicle is pretty unique. And in the first quarter, we showed for the very first time revenue-based KPIs in our DNR for the first quarter across both businesses, contracted and pay-as-you-go. And pay-as-you-go is a business that is more difficult to expand, it's at 117%. And that's, I think, a good indication of how fast we can take advantage of new products and how important expansion is to our business model.

What's the early thoughts in terms of how you planned to monetize Cloudflare for Teams? So in other words, what's the pricing look like? And what are traditional conversion rates from free-to-pay look like on other products?

I think the pricing question is easier to answer. It will be a seat-based offering, where for a certain amount of seats, you pay us a certain amount of dollars per month. And it will look like, from a pricing perspective, what you would pay for similar competitive products that are offered off our network. So from single-digit dollars per month to double-digit dollars per month, per seat, depending on the richness of what they buy. The conversion is a much more tricky topic. So we are still trying to figure that out. And when we provided guidance for the full year, we didn't really assume revenue from that product. It's for free until 1st of September. We wanted to see what the situation is going to look like by then. We don't want to -- we are not a company that is going to stand on every customer's footstep on the 1st of September, waving a contract and now you have to pay. We understand that we helped a lot of these customers are in really difficult situations, managing their transition from on-premise to work from home. And we want to be thoughtful and deliberate how we transition those customers. So we are still discussing a couple of options how we approach that. So the pricing is -- ideas and concept is firm, but how we transition that is smart. And for that very reason, it didn't reflect in our guidance for the remainder of the year.

Sounds good. You mentioned the dollar net retention. When you look across the business, how do you anticipate that metric will trend, especially in light of the current environment?

I mean it will go up, for sure. More products and larger customers will allow you to expand, so it will pick up over time. It will not pick up in a straight line. I think you'll see similar -- we'll see similar behaviors with us than you see from companies that look like us. Large customers never expand in a completely linear way, so that will give you some volatility, I want to call it, but it will pick up over time. So the 117% in the first quarter is across both businesses. And pay-as-you-go is a much more difficult business to expand, so it has good retention. But I think you see this extremely well in the cohorts that we published at our -- in our sponsor in the IPO, that the early cohorts from 2010, '11, '12 were primarily, almost exclusively, pay-as-you-go and they are pretty flat. So that's surprising. So all those customers were -- are still with us. They don't churn a lot but they're also more difficult to expand. And that reflects in the overall DNR number.

Yes. That makes sense. What about the large customer experience that you saw in the quarter. So the customers over 100,000, the growth behind it. And what are you expecting as you move forward on that front?

Yes. So our large customer count, and that is what we -- well, as large customers are now customers that we -- that have more than $100,000 of annualized revenue with us, grew 65% year-over-year in the first quarter. We saw a slight delay. I think on the earnings call, Matthew said it almost seemed like mid-March, they -- everybody took a pause, trying to figure out what happens and processes needed to be adjusted. How do you approve budgets and contracts when everybody's working from home? And I think also companies sorted their spend into categories. This is critical. This is less critical. This is where we stay. And we think we were sorted in the critical category. So we saw a pause in the second half and then it literally picked up in the last week of March. So from a new ACV perspective, we did -- we hit our plan. Actually, we're slightly better than what we had planned for the year. But because now that KPI is revenue based, if it's very back-end loaded, you carved less revenue out of the dollars you have billed. And that's why it was only 65%. And on a billing level, it was exactly where it used to be the quarters before and north of 70%. So this is our -- that's an important category for us. This is where we have seen significant growth over the last 2 years. It's our fastest-growing segment. And it has shown -- and the momentum has continued, from a trend perspective, in April and also now in May from what we -- from what I can see so far.

Fantastic. With that, Thomas, Jayson, thank you so much for joining us. We really appreciate it. Stay safe and healthy, and thanks again.

Thanks for hosting us. Always a pleasure, Sterling.

Bye.